Rupee slide: is there a case for a rate hike?

 The fall in the exchange rate of the rupee is the biggest concern at the moment. 

The current account deficit is expected to widen to around 2 per cent of gdp in the wake of the surge in oil prices. That is not a big deal by historical standards. We were comfortable with a CAD of at least up to 2.5 per cent of gdp, meaning we could find enough sources of foreign capital to finance the deficit.

Not so today. FII flows have been hugely negative and net FDI too has been negative. We could get public sector companies to raise foreign borrowings with a commitment from the government to cover exchange rate risk. We could resort to NRI foreign currency deposits. And the like.

But why not just raise the policy rate?

Former MPC member, Janak Raj, writing in BS, argues that we should not. He gives his reasons.

Empirical evidence suggests that defending an exchange rate with interest rates rarely works except in a full-blown panic, and even then, it requires very sharp hikes.

In theory, that's not true. Any rate hike, by raising the differential with respect to rates abroad, must cause the rupee to strengthen. Maybe not appreciably. But it should certainly help halt the relentless slide in the rupee. 

Further, he argues: 

The policy rate is an instrument for inflation control. Since exchange rate depreciation impacts inflation, the policy rate should be raised only if inflation breaches the target. That is, the MPC should only be concerned with exchange rate pass-through to inflation. 

By implication, the MPC should react only if the inflation rate exceeds the upper band of 6 per cent. At present, inflation is projected to be around 5 per cent.

The problem is that, if the MPC were to wait until the upper band is breached, the fall in the rupee would have fallen far too far for comfort. The momentum of rupee depreciation may become irreversible. Every fall in the exchange rate of the rupee has its implications for the fiscal deficit, given the reluctance to pass on prices fully to the consumer. 

So, with inflation projected to be in the region of 5 per cent, a judgement has to be made. Given the current geo-political situation, is there a prospect of oil prices rising above, say, $110 per barrel? Even at the present level, are FII outflows likely to persisit?

If the answers are in the affirmative, then there is a heightened probability of inflation breaching the upper band of 6 per cent. That creates the case for a rate hike. No need to wait until the horse has bolted.

Raj argues that the main problem could that India has taxes on capital gains that competing markets do not have. But that is a new situation. It has always been the case. Nevertheless, foreign investors have come in droves because stock returns in India too are higher so that the post-tax returns compare well with those in other markets.

The depreciation in the rupee is not the entirely the result of rising oil prices. Earlier, investors bolted after India was subjected to punitive tariffs by the Trump administration. Not that the CAD was seriously impacted but investor sentiment turned negative. We were told that they did not view with favour a market towards which the US administration had a hostile stance.

The point about hiking the policy rate is that we can expect the effect to be immediate. All other instruments will take time in producing results.